The end of back to back reinsurance?

In one of the most significant reinsurance decisions of recent years, the House of Lords last week unanimously allowed the appeal of reinsurers Wasa and AGF against the Court of Appeal's judgment in favour of their US reinsured, Lexington. The House of Lords held that although Lexington had settled various contamination exposures sustained over a 44-year period on the basis of a decision of the Supreme Court of Washington, reinsurers were not obliged to follow the settlement because the period of cover under the reinsurance should be interpreted under English law, by which it was clearly limited to three years.

This ruling brings into question whether reinsureds can rely on the back to back nature of reinsurance cover where the direct and reinsurance policies are subject to different governing laws. RPC Reinsurance Partner, Simon Kilgour, comments:

"Whilst providing some comfort for reinsurers concerned about the prospect of long tail asbestos and pollution exposures, this decision will make reinsureds wonder what they can do to secure back to back coverage for their business in future. The Lords suggested that the answer is in adapting reinsurance wordings to achieve the right result, and careful drafting will therefore be required on behalf of reinsureds to prevent similar dislocations in cover, particularly for proportional reinsurances."

Background and US proceedings

Lexington insured the Aluminium Company of America (Alcoa) under an "all risks difference in conditions" property damage policy for the period 1 July 1977 to 1 July 1980. Alcoa commenced proceedings against Lexington and other insurers to recover the cost of cleaning up contamination which occurred at numerous sites between 1942 and 1986.

As the direct policy did not contain an express choice of law, the Supreme Court of Washington held that it should be governed by Pennsylvania law, and that under that law, provided that some of the contamination occurred during the policy period, Lexington was liable to indemnify Alcoa for the entire period over which contamination had occurred. Following the judgment, Lexington settled Alcoa's claim for $103m. It then sought to recover the respective proportions from its reinsurers, Wasa and AGF, under a facultative proportional reinsurance with the same period as the direct policy. The reinsurance incorporated the terms of the direct policy and was subject to a "Full R/i Clause" containing a follow the settlements provision. The reinsurance did not have an express choice of law but was accepted by the parties to be subject to English law.

The decision and business implications

The decision raises numerous issues for buyers and sellers of reinsurance. Here we look at the important points of the decision and address how each one may impact on future cases.

1. The decision was made on the basis that at the time the reinsurance was entered into, it would not have been clear that Pennsylvania law was applicable to the direct policy, nor how that law would have allocated coverage for the losses in question. Therefore the parties to the reinsurance were not deemed to be bound by the interpretation of the period under the direct policy according to Pennsylvania law.

• This means that prudent purchasers of reinsurance may need to ensure either that a reinsurance contract is subject to the same governing law as the direct policy or that, if different, the governing laws of both contracts are at least identifiable at the time the reinsurance is purchased, and preferably that it is clear how key provisions in the direct policy will be interpreted. In practice, it will be difficult to obtain clear advice on the interpretation of many provisions in jurisdictions without established reinsurance case law, and this may place an unrealistic burden on the reinsured.

2. In previous cases involving similar issues, warranties in direct policies had been given the same meaning under the respective reinsurances, which were subject to different governing laws from the direct policies. The House of Lords distinguished those authorities from the current situation on the basis that the applicable law of the direct policies would have been clear at the time of placement. They remarked that the reinsurers' defences in the earlier cases had been unmeritorious, in contrast to the current case where they had sympathy for the reinsurers' position and upheld the first instance judgment which had found that the period clause was a fundamental term of the contract.

• This raises the question of whether the interpretation of a clause from a direct policy should be decided under the reinsurance according to whether it relates to a fundamental term of the reinsurance, and whether the relative equitable merits of the parties will be a persuasive factor.

3. The decision was based on the English law principles that as a "losses occurring during" policy, the only property damage which the reinsurance covered was property damage occurring during the three year reinsurance period. Lord Mance said: "To treat excess of loss policies as covering losses through contamination occurring during any period, so long as some of the contamination occurred or existed during the reinsurance period, would be to change completely their nature and effect."

• In upholding the natural meaning of the period clause, the decision will provide relief for reinsurers of US insurance business in run-off which may have included exposure for long tail asbestos and pollution and contamination liabilities.

4. The Lords rejected the proposition that the direct and reinsurance policies should be treated as back to back simply because the language used in both was identical and because Lexington had intended to cover the whole risk (excess of the retention). They said that this was a matter of "construction of the particular reinsurance contract against its relevant background and surrounding circumstances".

• By rejecting an absolute rule in favour of an approach which depends on the facts and circumstances of each case, the decision may increase the uncertainty of interpretation for reinsureds and reinsurers alike.

5. The reinsurance in question was a proportional facultative contract, which provided the strongest contractual relationship for a reinsured to argue for full back to back cover.

• As the House of Lords failed to apply back to back cover to the reinsurance in question, their decision should also apply to other forms of reinsurance, including treaty and excess of loss, which are by their nature less closely related to the direct policy.

6. The House of Lords found that a reinsurance such as the one in question was an independent contract to the direct insurance, and that the subject-matter reinsured is the original subject-matter. They rejected the view that a reinsurance may be an insurance of the insurer's own liability.

• This clarifies a fundamental point of reinsurance law which, whilst largely academic, may be used to advance new theories in respect of the reinsured's insurable interest, the amount recoverable by the reinsured, the limitation period for reinsurance recoveries and what a reinsured has to prove in order to make a claim.

Conclusion

As to whether this decision marks the end of back to back reinsurance, whilst the consequences may be wide-ranging, the Lords did not intend that to be the result. The existing case law was tested to the limit by the highly unusual circumstances of the case. Nevertheless, it may give rise to further disputes involving similar issues where reinsureds will seek to distinguish this decision on the facts, whereas reinsurers will seek to apply it.

The key challenge for reinsureds will be to ensure that, where possible, they are covered for legal risk arising from an unexpected judgment under a direct policy which is subject to a different governing law to the reinsurance. Whilst this could be achieved by specifying that the reinsured should be entitled to indemnity against whatever liability it may be found to have by any court under whatever law was applied, the reinsurer may well object on commercial grounds.

Lord Collins noted that after banking, insurance is the UK's largest invisible export, of which reinsurance forms a large part, and it will be interesting to see whether this pre-eminent position is enhanced or diminished in the light of this decision.